Exchange rate risk affects a nation's import and export business; as currency falls against an opposing nation, imports become more expensive and exports go up thanks to relatively cheaper prices. Such risks pose a huge threat to any economy and can be influenced by a number of factors. The price of commodities, central bank rates and inflation are the major contributors of exchange rate volatility.
Commodities are inversely related to currency values in most cases. A commodity is a hard asset class that investors flock to as a safe haven when currency values fall, so trading patterns can emerge that temporarily affect exchange rates. The exception to this rule applies to economies whose main industry is tied to a traded commodity. For example, the Canadian dollar moves in correlation to Oil prices; as oil rises, the value of the Canadian dollar rises with it.
Central Banks play a pivotal role in affecting exchange rates. When interest rates in one country are higher than rates in another country, it offers lenders a chance to gain higher returns by investing in the country with higher rates. Higher interest rates attract foreign investment, and when investors purchase a country's currency, they will cause the exchange rate to rise.
Inflation is the unseen destroyer of currency value, because high inflation relative to another country will depreciate their currency. The effects are generally temporary, however, as inflation will cause interest rates to rise in order to counter the inflationary impact on the economy. The devalued currency may continue to stay at depressed values if interest rates are significantly lower relative to other country's currencies.
Dealing with Exchange Rates
The impact exchange rates have on the global economy affects all forms of international trade, stock prices and bond rates. Because currency values are only measured in relative terms against other currencies, they are popular assets to trade. A common investment strategy known as a carry-trade will short the currency of a country with low interest rates and buy the currency of a country with relatively higher rates, generating a profit and pushing the exchange rate difference higher.
- Modern Portfolio Theory and Investment Analysis; Edwin J. Elton, et al.
- Getting Started in Fundamental Analysis; Michael C. Thomsett
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